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There is consensus among analysts and bankers on a repo rate cut in the Reserve Bank of India’s policy announcement on January 29. However, they seem to be divided on the quantum of the cut. Whether it is 25 bps or 50 bps, it will be the second rate cut since the RBI slashed it in April 2012 by half a percentage point to 8 per cent after 13 hikes spanning more than three years.

Edelweiss expects the RBI to cut the repo rate by at least 25 bps and keep the CRR unchanged in its monetary policy review. The cut is highly anticipated as inflation (on trend basis) has come down sharply after its explicit guidance of rate cut in Q4 FY13 while the government has continued its reform momentum (special focus on curtailing fiscal deficit and boosting investments).

In its last policy announcement in December 2012, the RBI raised concerns regarding global economy, the activity in the US and the UK and the near-term prospects in the eurozone, and pointed out that it was expecting clarity on how the US ‘fiscal cliff’ might be managed. There have been some improvements since and the central bank is closely monitoring the evolving growth-inflation dynamic and will update the formal numerical assessment of its growth and inflation projections for 2012-13 as part of the third quarter review, which is expected tomorrow.

On the domestic front, the major concern of the RBI is the inflationary pressure on the economy and it gave some signs of easing in the coming months.

Most of the bankers and analysts are unanimous in their call for a rate cut because of the belief that monetary affects real economy, at least in the short run. Here are the three key factors that will impact the banks and the non-banking finance companies (NBFCs) when the RBI makes its policy announcement.

Repo rate cut

An interest rate hike has a significant negative impact on the growth of aggregate demand while a repo rate cut is followed by reduction in the base rates of the banks. Although it is widely expected that the base rate cut may not follow immediately, the April 2012 experience indicates banks may follow suit. In fact, the banks and the NBFCs are now witnessing one of the slowest credit take-offs.

Credit during the first nine months of the financial year was just 7 per cent year on year, compared to 10 per cent YoY last year, while the deposit growth reached a nine-year low when it grew just 11 per cent YoY in the fortnight ended December 28, 2012.

Considering the lower non-food credit growth, banks are more likely to pass on the benefit to borrowers.

Guidance

In its previous policy announcements, the RBI always made efforts to clarify its guidance for the upcoming quarters. On Oct 30, 2012, the central bank reduced the cash reserve ratio (CRR) by 25 bps. CRR is a portion of the cash that commercial banks need to park at the RBI on which they do not earn any interest.

The decision to cut the CRR and keep the policy interest rate unchanged was drawn from the RBI’s assessment of the evolving liquidity situation and the growth-inflation dynamic.

It has also sent a message to the economy that the baseline scenario suggests a reasonable likelihood of further policy easing in the fourth quarter of this fiscal year. In the past, too, the Ministry of Finance indicated that the economy needed a rate cut from the central bank. These are messages that the bankers and the industrialist are closely reading for their growth plans.

Liquidity constraints to ease

Commercial banks borrow short-term money from the RBI to meet temporary asset-liability mismatches (ALM) at the repo rate and park their excess money at the reverse repo rate, currently at 7 per cent. Liquidity conditions have remained tight in the third quarter due to large government balances with the RBI and the widening wedge between deposit and credit growth. With a view to containing the liquidity deficit at reasonable levels, the RBI conducted open market operations (OMOs) on December 4 and 11, injecting primary liquidity of Rs 232 hundred crore. It will either go for a CRR cut to ease the liquidity constraints or continue with OMOs in the future as well. However, there are issues arising because of the advance tax payments, which will negate the efforts of the RBI.